Smart money on SmartHeat? Well, despite the large sell-off, it’s not thàt cheap yet..

Here is a company that produces a relatively simple industrial era commodity product. That would not normally catches the eye of investors looking for high growth opportunities, except for the fact that this company is based in China.

Their product enables clients to save energy for heating buildings. It’s a ‘plate heat exchanger’ (PHE’s), which is pretty standard fare in developed countries, but in China most buildings are heated by house coal-burning boiler systems using shell-and-tube heat exchangers. According to an article in the Business Daily, the plate heat exchangers are twice as efficient.

So now one might realize that the market opportunity is really huge. However, a huge market opportunity doesn’t normally translate into huge profit opportunities with commodity type products. Ask D-Ram memory producers.

However, there are three reasons why this logic is suspended at this point (and we expect for quite some time to come):

1. The market is in the early stages of it’s growth phase. This enables most players to expand without resourting to price competition, keeping margins intact. It’s only when overall market growth starts to taper off that price competition sets in in these types of commodity markets.
2. That growth is further enhanced by the $31B in the Chinese stimulus program ($586B overall) directed at energy efficiency.
3. SmartHeat has one trick up it’s sleave here that gives it a heads-up on the competition. It has a ‘distinctive capability’ in the form of proprietary software that allows to identify PHE needs for proposed structures in real time and can provide a contractor with an on-the-spot quote, rather than the multiweek quote process that peers require.

So their core market is in very good shape, but they have additional opportunities in the form of heat meters and vertical integration.

China is only recently moving to including metered heat provision in buildings. In 2003, this was mandated for all new buildings (and considering the amount of construction going on in China, this already provides a significant market). In 2008, China expanded the law to retrofit older buildings.

Selling the meters themselves is already a rapidly growing opportunity. Sales rose from $500,000 in all of 2008 to $7.8M in the third quarter of 2009. But metering buildings will make clients much more energy aware. The old saying from operations management goes that you cannot improve what you don’t measure.

Vertical integration offers another opportunity. In June it bought Siping Beifang Heat Exchanger Manufacture Co., and this enables them to make the plates for their PHE’s in-house (instead of buying them from Denmark’s Sondex). It will enable the company to keep profits in-house and serve customers faster.

Metrics [Yahoo]
– Solid operating and profit margins (26% and 22%)
– $60M in cash, $6.5M in debt
– 41.5% of shares are held by insiders

Metrics [Yahoo, average of three analyst]:
– Revenue is rising from an estimated $80M in 2009 to $115M this year
– Profits will rise from 64 to 74 cents over the same period
– The company has a nice history of positive earnings surprises
– It’s 2010 p/e is 15

Risks

1. Negative cash-flow. The latest quarterly report (p.23) has a negative cash flow of just over $6M for the first nine months of 2009. It’s not unusual for a company with this growth profile and they have plenty of cash on hand. In fact, it’s somewhat similar to the situation at Fuqi.
2. There are of course other business risks. The Chinese economy might slow, competitors might develop superior products, stuff like that. For us, these do not represent immediate risks, it seems that the market for energy efficiency in China is likely to continue to offer very solid opportunities for this and many other companies.
3. Shares keep on falling. This, for us is by far the biggest risk. It’s not quite certain to what extent the Chinese authorities are embarking on cooling off their economy. We don’t think these efforts will dent the market opportunity for HEAT, but it could very well further erode investor sentiment and lead to further price falls for the shares. While a p/e of 15 is not expensive, further price falls are very well possible as comparable growth stories like FUQI are considerably cheaper.

Technical picture
It has broken the support at $12 but is still (just) within the upgoing trend. You might wanna wait until that is confirmed.